The Reserve Bank of India (RBI) has lowered the policy rates by 25 basis points. But the question remains whether it will make any difference to the trends in inflation and growth.

The persistence of inflation appears to defy the understanding of the authorities. I called it “Inertial Inflation” and indicated some of the contributory factors (“When inflation perpetuates itself”, Business Line , July 28, 2010). It took quite some time for the RBI to recognise it (para 1.48 of Annual Report of RBI for 2010-11).

Action on demand side

What has not received the attention of the observers is the fact that rural inflation, as measured by the Consumer Price Index, is even higher than that in urban areas.

In February 2013, the rates for rural and urban areas were 11.01 per cent and 10.84 per cent, respectively. What is more, in rural and urban areas, inflation in the food and beverages category stood at 13.53 and 13.87 per cent, respectively.

This should be surprising because the rural areas are the sources of agricultural supplies. The average Indian farmer keeps a proportion of his foodgrain output for family consumption.

In fact, in the case of subsistence farmers, the entire output may be adequate only for self-consumption. Still, he is forced to sell the output to meet his liabilities, especially the repayment of loans to institutional and non-institutional agencies.

These are factors that should militate against any increase in food prices. There is no doubt that the pumping of funds into rural areas in employment schemes without any corresponding growth in output has aggravated the situation. Hence, it is a major factor on the demand side that has contributed to the current situation. The movement of the inertial equilibrium of inflation to a lower level could be influenced by administering shocks on both the demand and the supply sides.

There is not much the RBI can do on the supply side. That despite mounting stocks of foodgrains, which will grow further once the rabi procurement of wheat starts on April 1, cereal prices are a major cause of inflation is a testimony to mismanagement on the part of the authorities. The RBI can initiate ameliorative action on the demand se.

The central bank takes comfort in the fact that the growth in money supply so far has been on the expected trajectory (13 per cent) for the year. But is it not validating the inflation rate, given the fall in growth rate?

Need to review LAF

The role of created money has been substantial. As on February 22, 2013, the total growth in money supply (M3), year on year, was nearly Rs 9 trillion, of which 11.6 per cent was the RBI’s contribution by way of net credit to government.

The latest Report on Currency and Finance of the RBI has clearly articulated the fact that, despite the Fiscal Responsibility and Budget Management Act, de facto monetisation of fiscal deficit occurs through large Open Market Operations (OMO) with inflationary consequences.

Perhaps, this is the first time that the central bank has admitted to what I have been calling retroactive monetisation of fiscal deficit in OMO without using the fig leaf of liquidity. (“Ways to handle forex crisis”, Business Line , May 23, 2012).

There should be some rethinking on debt buybacks. If, as a result of the RBI not entering the market with buybacks before a new floatation of securities, the interest burden on government goes up, so be it.

For the shock on the demand side to lower the equilibrium of inertial inflation, the RBI needs to have a clear idea of what liquidity measure it should use for calibrating money supply. Taking the repo transactions as a measure of liquidity is wrong for reasons which I have dealt with in the past.

The Chairman of State Bank of India is reported to have said: “Whereas a repo rate cut is more of a signal …it is not very material but, yes, the cost of refinance goes down”. ( Business Line , March 19, italics added). Was it a Freudian slip, since he knows that the repo window is not meant for refinance?

There ought to be some control over repo operations with an ex post facto investigation of how the funds are used by the banks. In fact, there is an urgent need for a re-look at the Liquidity Adjustment Facility before the Annual Review for 2013-14 to find out whether it meets the objective for which it was set up, or has been hijacked by banks for other purposes.

Deflation is the solution

The impact of the reduction in policy rates on growth is likely to be muted. In the first place, in the banks’ scramble for deposits, the rates are being increased, which will be a disincentive for lowering them on the lending side.

Second, the economic problem facing the common man is not just the rate at which prices are going up. It is the high level of prices that makes him cut down the quantity and frequency of his purchases of goods and services or avoid them altogether.

The solution lies not in disinflation but deflation . The latter term should not have the same frightening implication in the Indian context as it has for Japan.

It will mean that food prices have to come down through supply management to a level that is consistent with the growth in incomes. It will release purchasing power to buy other goods. How can investment grow in an environment marked by a fall in aggregate real demand due to rising prices?

(The author is a Mumbai-based economic consultant.)

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